Should King's Sour Candy Be Crushing Shares Of Glu?

Summary

King Digital Entertainment’s lackluster IPO has put a damper on shares of Glu Mobile. However, KING and GLUU are very different companies.

A $13.1 million increase in revenue enabled a $7.8 million increase in Q4 cash flow. Thus, analysts expect an 18.6% increase in 2015 revenue to produce a 600% EPS increase.

KING’s IPO gives credence to a current valuation in excess of $6.00 for GLUU. Calculations show that a megahit like Candy Crush would likely send GLUU to the $50 level.

King Digital Entertainment's (BATS:KING) lackluster IPO (along with an unfriendly market for small-cap stocks) have put a damper on shares of Zynga (NASDAQ:ZNGA) and Glu Mobile (NASDAQ:GLUU). However, investors need to realize that KING, ZNGA, and GLUU are very different companies. This article will focus on Glu Mobile and provide an update to my November 24 article, entitled Shares Of Glu Mobile Are Poised To Triple.

On March 26, King Digital went public in an IPO priced at $22.50. Considering the hype that led up to the offering, $22.50 was a clear let down for many investors. However, our due diligence at PTT Research led us to the conclusion that KING is overvalued, while GLUU remains underappreciated by the markets.

Thus far, the first part of that analysis has borne out in the marketplace. KING immediately began trading below its IPO price and has been falling ever since. On Friday, the shares closed below $19. We believe the stock will fall further in the months ahead. There are several reasons for this...

For starters, KING's valuation is more than fifteen times greater than GLUU's. After reading the IPO paperwork, I concluded that the majority of King's valuation is attributed to Candy Crush. Looking back to 2011, GLUU was actually a larger company than KING. However, Candy Crush (and its offshoots) added over $1.5 billion to KING's revenue line. That's right - billion, with a "B".

That's the power of a megahit game. However, nobody can predict what the next one will be (or who will produce it). That being said, I believe that leading mobile game companies like KING, ZNGA, and GLUU are best-suited to do so. They have the development resources and monetization know-how that most mobile game makers don't (or can't).

Indeed, the barriers to becoming a successful mobile-gaming company have become steep.

Thus, when valuing shares of GLUU, investors need to consider its operating model leverage (OML) and what will happen to the stock if GLUU delivers a megahit like Candy Crush.

Starting with GLUU's OML, we need look no further than its Q4 report to see that each incremental dollar catalyzes a significant increase in profits. In the September quarter, the company posted 21.7 million in revenue and operating cash flow of -$5.9 million. In the December quarter, that number rose to $34.8 million in revenue and $1.9 million in operating cash flow.

So, a $13.1 million increase in revenue enabled a $7.8 million increase in operating cash flow. This is why analysts expect an 18.6% increase in 2015 revenue to produce a 600% increase in EPS. That's right, six hundred percent. Thus, as revenues continue to grow in 2016 and beyond, the company will continue to generate substantial earnings growth.

Accordingly, I expect that it will garner a commensurately healthy P/E ratio. If we estimate 30-cents of EPS in 2016 and apply a 30 P/E, the result is a $9 stock by mid-2015 (when Wall Street will likely begin to value companies on 2016 expectations).

That's a 115% return from Friday's closing price...and one of several reasons I selected GLUU as a pick to triple when it was trading at $3.

Moving on to the "megahit factor", we find that Candy Crush took KING from a company that was smaller than GLUU to one that is several-fold larger. If we look at the valuation impact (and ZNGA's before it, from back in the Farmville days), a similar megahit would likely send GLUU to the $50 level.

Basically, that possibility represents a lottery ticket that comes free with the purchase of each share.

Accordingly, it comes as no surprise that Cowen & Company came away optimistic after talking to management and seeing the King's IPO filing. Nor should it have been a surprise to see GLUU hit a new 52-week high on the news. The subsequent decline has not come as a surprise (given the myopic nature of the stock market), but is baffling nonetheless. Wall Street price targets extend as high as $7.50, well within the range of my $9.42 target.

In addition to GLUU's continued execution, M&A is abounding in the mobile gaming space. Recently, Brightwire reported that Alibaba is planning to buy units of Shanda Interactive and Shanda Games' (NASDAQ:GAME) for $3.2B. In January, Shanda Games was offered $1.9B.

This was just the latest in a wave of mobile gaming activity. In my opinion, it presages higher valuations for GLUU. According to our calculations, KING's IPO gives credence to a current valuation in excess of $6.00 for GLUU. Simultaneously, our proprietary Risk/Reward Chart suggests that shares of GLUU are prepared to support that valuation.

Accordingly, on March 13, PTT Research officially changed GLUU's classification to "Gold Mine".

A few days later, GLUU released new Deer Hunter 2014 content, which propelled the game up the charts once again. DH14 continues to demonstrate amazing resilience, boding well for GLUU's March quarter, which came to a close on March 31.

Meanwhile, the competition continues to suffer. Disney Interactive recently cut 700 jobs. The Wall Street Journal reported that the layoffs would "cut across several divisions," including kids' gaming. It is also becoming widely known that Electronic Arts is moving away from casual gaming. It has retrenched and decided to focus on its roots in high-end console gaming.

These events represent the latest in a growing line of large vendors that have failed to develop a successful monetization platform in the mobile gaming space. Of course, this leaves GLUU with less competition and more potential suitors. With these big players bowing out, the competitive environment seems to be leveling off, even as the space continues to heat up. Most of the remaining competitors are smaller and, in my opinion, are going to find it increasingly difficult to match GLUU's game-development budget, further augmenting GLUU's market position.

Beyond that, our view hasn't changed at all since we initiated coverage and we expect a positive Q1 report in a few weeks. The company continues to make great progress and remains poised to triple.

Disclosure: I am long GLUU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Portions of this article appeared in the PTT Insider newsletter on April 4. I am also short shares of KING.